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March 13, 2013

Price vs. Value: More Thoughts on Valuing Advisory Firms

I’ve received a number of emails in response to my March Investment Advisor column: “High Flyin’” about Chicago-based HighTower Advisors’ formula for acquiring advisory firms. Most of these comments challenge the idea of valuing independent firms based on their revenues, rather than on their profitability. While I don’t completely disagree with these sentiments, I do suspect that the bottom line in an acquired firm is less important than some folks seem to believe.

Here’s how one advisor put his objection: “As a buyer, it is very important to use the seller’s profile of profitability, analyze their business model against the buyer’s, and derive a number for anticipated operational margins. Added expenses will be greater than zero. AUM is not a good place to start for valuation; neither is revenue. Asset quality derives from net income per client and net income per account. Ultimately true value is in the cash flow derived from the acquisition over an extended period.”

Another writer put it more succinctly: “Cash flow has to support the purchase price or it is a bad deal unless you are making a strategic move to create a platform that you can build upon.”

It seems to me that if one were to simply buy an independent advisory firm, with the intention to continue to run it as a standalone business (as a junior advisor within the firm, or an advisor new to the business might do), then, certainly, the operating margins of the firm would be an essential element in the purchase price and deal structure. That is, after one factored out any understatement of profits or additional “benefits” that the former owner of a small business might have factored into the expenses. However, if the buyer is an advisor with an existing firm, the margins of the acquired firm become less important.

For one thing, buying firms often have existing excess capacity to handle more clients than they currently have (which is why they are making the acquisition): therefore, the additional costs to service new clients can be quite low. In many of the FP Transitions deals, for instance, buyers acquire firms that would add, say, 20% more assets to their existing AUM, and that from new clients who are very similar to their existing clients. In these cases, "increased" operating costs are minimal.

Secondly, buying firms are often very secure in their own successful cost structures for servicing their clients. Consequently, they're not terribly concerned with how efficiently the selling firm (which they will essentially be shutting down) has been operated. In fact, "sophisticated" buying firms actually look to acquire inefficiently run firms, in the hope that the selling advisor will undervalue their firm.

But whether the buyer is looking to integrate additional clients into his or her own firm, or intending to operate the purchased firm as a standalone business, he or she has to play particular attention to the quality of the clients—and their assets—being acquired.

That “quality” would include clients’ age, their degree of loyalty and whether there is anything about the new client base that is more expensive to service than the existing clients. That is why most deals are done between firms with very similar client bases, in terms of AUM/client and investment needs. And most deals—whether they are revenue or profit based—include incentives for the seller based on the transfer and retention of the clients and their assets.